Making way for green mortgages

Transcription

Emma Bill:

Hello everyone, and welcome to Cornwall Insight's latest podcast. My name is Emma Bill and I am a lead research analyst at Cornwall Insight. Today, we're going to talk about one of the themes covered in our report with TLT, the law firm, on green finance and financing green. The report can be downloaded at both ours and TLT's websites. And it also involved a launch webinar, which is available to listen back to. And just for your ease, we'll include the relevant links on the landing page for this podcast episode, if you want to delve further.

So, today I'm really excited to be joined by contributors to the report, Emma Harvey of the Green Finance Institute and Robin Penfold from TLT, where they're both going to be discussing the important role of green finance products and services with a particular focus on green mortgages and alternative green financing models.

So, Emma and Robin are going to share with us their insight on the developing market for green mortgages. And as I said, the alternative solutions pioneered in the US, for example. They will also give us their views as what needs to come next in the UK, including from a legislative and regulatory point of view, to realise the potential of green financing in delivering the important energy efficiency target, and ultimately net zero by 2050.

Without further to do, let's go to Emma and Robin to introduce themselves and share their initial views on this topic – in the context of the UK government's current policy commitments for decarbonising homes and buildings. So, who wants to go first?

Emma Harvey:

I'm happy to introduce myself, Emma. So I’m Emma Harvey, I am a programme director at the Green Finance Institute, and I run our built environment programs at the institute, which consists predominantly of the Coalition for the Energy Efficiency of Buildings.

A little overview of what we do at the Green Finance Institute – so we were set up two years ago by the UK government and the City of London Corporation, with a focus on financing green and mainstreaming green finance in the UK and internationally. The way we do this is by convening sector-focused coalitions that aim to identify the barriers to investment into decarbonising particular sectors, and then work through the industry to collaboratively develop the financial solutions needed to make money move at pace and at scale.

Emma Bill:

Thanks, Emma. Robin?

Robin Penfold:

Hi, so I'm Robin. I'm a partner in TLT’s financial regulation group and specialise in mortgage law and regulation. And I think ready availability of private finance is critically important to decarbonising and adapting the UK's housing stock, to drive energy efficiency and ultimately support the delivery of net zero targets. So I'm really excited about the opportunities for the home finance market to support this transition to a low carbon economy, and to be talking about this today.

Emma Bill:

Thanks. No, it's great to have the opportunity to talk with you both. So I'll dive into the first question that we have for you. Emma, I'll direct this at you in the first instance. So what do we mean by green finance products and what are the advantages of a green mortgage for prospective homebuyers, banks and net zero targets?

Emma Harvey:

So, before diving into green finance products, I'll probably take a step back and just explain what we see as being green finance more broadly at the Green Finance Institute. And we see it in two bubbles – there's greening finance and financing green. Greening finance focuses on reporting disclosure, managing the risks associated with the climate transition. Meanwhile, financing green focuses on mobilising capital towards real economy outcomes. So it focuses on product innovation, upskilling financiers to be able to have fluid conversations with customers on decarbonisation, and it also focuses on having more engagement with clients and customers as well.

So in that context, we've seen a lot of activity in the corporate finance space. We've seen green bonds, green loans, sustainability-linked loans. But the consumer finance sector has been slightly behind on green finance products, but that has changed a lot in recent years.

And we've seen green mortgages become the poster child for the green consumer finance sector. Now in short, green mortgages are like any other mortgage, but they offer financial incentives, be that lower interest rates or higher borrowing capacity to homeowners or landlords who are looking to undertake green activities on their property, or if that customer is looking to purchase an already energy-efficient property. These have been around since 2006 when Ecology Building Society launched their very first product. And since 2018, we saw products being launched by the likes of Barclays and in the last couple of years, we've seen the likes of NatWest, Lloyds, TSB, Leeds Building Society etc. bring to market these products. So we're aware of double-digit numbers of these products on the market and we believe various different actions are helping to actually stimulate further growth and innovation in this space.

Robin Penfold:

I think as Emma was saying, I mean, it's really exciting to see the growth of the market particularly over the last 12/18 months or so. And we've seen a real variety of products launch into the market, from green home discount products to those that are designed to support green home improvements, to additional green loans. And we can see how the UK is now slotting into what's happening in international markets too. And a real range of maturity across those different international mortgage markets, with probably the Netherlands leading the way, where energy efficiency is given real priority by many borrowers across the market. So it's really exciting to see the developments that have happened over the last 12/18 months in particular, but particularly what's to come.

Emma Bill:

That's really interesting, particularly sort of the, what's going on elsewhere as well. So what are the biggest barriers to green mortgages in the UK, in your views? And how can they be overcome?

Robin Penfold:

So I think from a consumer demand perspective, although there's anecdotal evidence across the mortgage market that customers are more ready than ever to start having conversations about energy efficiency (and I think that's in part because climate change is becoming a mounting concern in society as a whole, and energy efficiency is becoming increasingly prominent in many spheres of life) there are challenges from a demand perspective.

I think firstly, the familiarity of borrowers with energy efficiency is often patchy. A majority of customers probably wouldn't know their home’s EPC rating. And it's often to date not been particularly central to the home purchase decision or the mortgage journey. And although I think there's a widespread desire now across the consumer market to make energy efficient changes, there's a bit of a gap in terms of the willingness, I think, to take action – partly as a result of some of the practical limitations to making home improvements. Some people like living in a historic home with character, which can be quite difficult to adapt. And the benefits might not always be clear to customers and they don't necessarily feel the urgency to act now. And for some, they might see high barriers to carry out the work, so historic perceptions about the cost of energy efficient improvements and what impact that might have on the home.

So I think, on the one hand, the demand is not quite where everyone would want it to be. I mean, in terms of what might solve that, I think further tools to enable customers to understand the energy efficient benefits of home improvements and the financial benefits to encourage that demand would help. On the other hand, you could look at what may be being explored as minimum legislative standards, so that there's a clear urgency to act.

I think from the supply perspective – and I know we'll probably come on and talk about this a bit later – some of the challenges are pricing of these products in the market (a very low interest rate environment, and a very competitive mortgage market at the moment), and some of the challenges I think from a market where it's heavily intermediary-led and heavily advised, on the advice that's given to customers. And again, some of the challenges from pricing, but we'll no doubt come on and talk about this shortly.

Emma Harvey:

Just to add a couple of points to what Robin said, completely agree that the certainty of demand from customers for retrofitting is one of the barriers to market growth. We at the institute undertook some consumer research to understand attitudes around energy efficiency. 83% of the people we surveyed said they were interested in energy efficiency. And yet, when you drilled down into their knowledge and understanding of what energy efficiency meant, half of those we surveyed didn't know their EPC rating. Another 10% had never heard of an EPC rating, and their understanding of what a deep retrofit was didn't extend far beyond energy efficiency appliances.

So as Robin said, there's some really important pieces around providing information and upskilling the public and then supporting that demand so that financial innovation follows. I think, sort of two other pieces. I think we sometimes overlook the R&D investment that's needed to develop new green financial products and how they can sometimes be operationally disruptive to financial institutions. So support schemes, such as the Green Home Finance Innovation Fund that we saw launched by the UK government a couple of years ago, was a welcome move to try and help address that barrier to innovation.

And then, I think there's a broader question around innovating products that offer benefits to customers while at the same time offering commercially attractive risk-adjusted returns to the financial institution. And one area – if we turn our gaze over the pond and have a look at some models that have been successful in the United States, that have achieved both those goals – we've seen something called Property Assessed Clean Energy finance be very successful in this space. And I know we'll be touching on that again a bit later so I won't steal the punchline! But it's a very well-proven product that addresses the payback barrier that many homeowners face to retrofitting, but also delivering returns that institutional investors can get behind.

Emma Bill:

Exactly my next question. I think you've pre-empted that, Emma. So what we want to understand is what do green mortgages and the PACE model (the Property Assessed Clean Energy model), what does that mean for the UK consumer and how can we make that work in our context?

Emma Harvey:

Fantastic question. And I think I'll take a little bit of time to introduce Property Assessed Clean Energy finance, or what we like to call property linked finance, because it's quite a new concept and new financial structure for the UK. So normal financing is linked to the property owner. When you take out a mortgage, you as the homebuyer are responsible for the repayments on that mortgage. Now, and that's very much similar with all financing models in the UK. However, property linked finance actually links the repayment obligation to the financing, to the property. So whoever is living in that property is responsible for repaying the financing that was taken out to, for instance, pay for an energy efficiency improvement.

Now, as I mentioned just earlier, one of the big barriers to people retrofitting their home is the high upfront cost and the expectation that they're not going to see the full economic returns from those energy efficiency measures throughout the duration of living in their property. With property linked finance, that's not a problem because if you moved home two years after retrofitting it, you're not going to have to carry on repaying for some measures that you're no longer benefiting from. Whoever is subsequently living in your property and has a warm, comfortable, more energy-efficient and cost-efficient home to live in is the one who repays this.

So if you contrast property linked finance with green mortgages, both are clearly facilitating and helping homeowners to undertake green activities in their property, whether that be heat pumps, insulation, solar panels etc. And for lenders, it's helping financial institutions have a greater dialogue with their customers as well. They're getting to understand their customers' green ambitions, but they're also gathering additional information on the green activities that homeowners are undertaking. One of the big buzzwords within the green finance sector is “greenwashing” and therefore lenders being able to verify that green activities have genuinely taken place in a property and are delivering carbon emission savings or resiliency benefits is absolutely vital. So you're going to see a greater dialogue and to-and-fro of sharing information between borrowers and lenders.

So again, both are helping facilitate green activities. They can offer favourable financing rates versus if you went to the traditional borrowing and investment market. But one of the areas that really does need to be addressed as well, and where financial institutions can play a facilitating role, is then helping their customers, those homeowners, be connected in with the supply chain, be connected in with reputable suppliers etc. So while that's not necessarily the core business of a bank or a building society, that can be one of the big hurdles as Robin mentioned earlier, that can be one of the big hurdles for someone actually turning their ambition into implementation. So still developments for the industry to explore in the facilitation and connectivity piece of the retrofit supply chain and value chain.

Robin Penfold:

Thanks, Emma. I completely agree. And particularly around this concept of almost connecting up the different aspects of home financing and that being something that the PACE model operates. If you look at other aspects of the financial services sector, particularly if you look at the way current accounts work these days and how those are packaged up using open banking and all of the different services connected to your life that you can manage through your account provider.

The same thing doesn't exist in a sense in the mortgage market at this stage, very much the customer goes to take a mortgage and that's their relationship with that mortgage lender. But what this really offers is that opportunity to connect up almost the kind of financing of the home and the home itself and providing all of those ancillary aspects around it, whilst also enabling the lender to have more control over how their security is protected. So that feels like a real opportunity there, but in a sense, a real mindset shift in the way that property finance works in the UK at the moment to achieve that. To achieve the concept of, in a sense, a very simple level finance attaching to the home and not to the individual.

Emma Bill:

How does the current legislation and the rules need to change to facilitate more uptake of green mortgages or equally the uptake in PACE style models?

Robin Penfold:

So I think the way in which the mortgage market works at the moment is, as we sort of talked about, it's advice-led – typically by an intermediary, either together with the lender or the intermediary providing advice on their own in terms of the best product for the customer. And typically the way in which they make that decision is also very kind of interest-driven and price-driven. So in a sense, having to sell the cheapest product to the customer that best suits their needs, unless they can explain why they've made an alternative decision. And those rules potentially create some challenges from the perspective of the existing products in the market, because the green finance products in the mortgage market are currently structured as, in a sense, standard mortgages. So you are comparing them alongside what might be some of the main high street lenders’ sort of leading five-year, three-year, two-year fixed rate products in a very competitive interest rate environment.

And quite often at the moment, the consequence of that is that a green mortgage product might not necessarily be cheaper than that other, I call it mainstream market-leading product. And it might be difficult therefore for an advisor to take into account the customer's preference, for example for a green mortgage product over that kind of pricing differential. So I think there's an element of advisors getting more confidence around how they make some of those advice decisions and the extent to which they can take into account the customer's preferences. In a sense, in part, this could be solved through the development of a PACE model, because if you had a product that was in the market that operated completely differently, you wouldn't in a sense be comparing apples with apples. It would be quite a different proposition, and that may open up some opportunities in the market too.

The other, I think key knowledge gap, in a sense, is the understanding of the extent to which particular energy improvements deliver benefits to customers and the extent of those financial benefits. And in a sense, that's always caused challenges with some of the financing of this technology, because the customer might be paying a loan with a repayment profile that operates in one way, and actually the energy efficiency benefits and the cost savings to the customer might deliver on a completely different financial profile. And so again, something like a PACE model where there's more alignment and repayment over an extended period and attached to the home rather than an individual borrower, for example, paying the upfront cost of that work before then moving home could again make some quite significant differences in the market.

Emma Harvey:

Just picking up on one of Robin's points around, how do you actually communicate these products to the consumers? Let's not forget that the broker community, so the mortgage intermediary community, is highly, highly influential in the UK mortgage market. Approximately 70% of mortgages are originated through brokers. So as well as innovating these green mortgage products, and even these PACE products, there needs to be communication, not just with customers, but actually with brokers, so that they feel confident enough to have those conversations with customers to understand their green desires. I previously worked at a financial institution and we launched a green mortgage product. And it was amazing how the mortgage intermediaries would say they'd had a conversation about green with their customers and saw them come to life. It's a topic that people can get very passionate about. We just need to convey to the industry that people can get passionate about this topic.

Just on another regulatory lever for supporting green mortgages or finance towards green, more generally…One of the recommendations that have come out of various different reports from the Green Finance Institute and other organisations, is around the opportunity to embed EPC accurate energy bills into mortgage affordability calculations. So a couple of years ago there was a project called ‘The Lenders Project’, which assessed how much a customer could borrow on their mortgage if ONS average statistics were used in the mortgage affordability calculation, and then if an accurate energy bill was used in their affordability calculation. And the results were between 5 and 10 grand more could be borrowed if accurate energy bills were used. Now, we don't see many lenders applying this within their standard calculations. This is another way of helping to nudge the market in the right direction and to demonstrate that value that is held with a more energy-efficient property. So I think moving away from the consumer piece, I think that's one area that lenders really could be looking at in the future just to try and eek out those extra little benefits in this space.

Emma Bill:

One of the topics we would like to cover is the work that you've been undertaking with the Green Finance Institute and the Green Home Finance Principles. Could you talk a little bit about how these feed into the discussions we've had today and what success we've had to date?

Emma Harvey:

Absolutely. So the Green Home Finance Principles were developed by the Green Finance Institute in partnership with members of our Coalition for the Energy Efficiency of Buildings, of which TLT are one of our leading members, and the Loan Markets Association. And if you are familiar with the Green Bond Principles or the Green Loan Principles, the Green Home Finance Principles are a retail banking equivalent focused on energy efficiency homes. So the Green Home Finance Principles are in effect guidelines for financial institutions on how they can ensure that any money that goes towards energy efficient homes, through green mortgages or retrofit loans, that they genuinely are channelling the money towards green activities. And it helps to embed consistency and transparency into the green mortgage and retrofit finance market.

And it's formed of four core pillars. One is the use of proceeds. The second is around the process for project evaluation. The third is around how funds are managed. And the fourth is around reporting (so having a dialogue, as I mentioned earlier, between the borrower and the lender). So since the Green Home Finance Principles launched in September 2020, we have seen 11 financial institutions align or commit to align their green mortgage products with the principles, and they represent approximately a third of the UK mortgage market by balance sheets. And we know that they are continually innovating new products, and we're in conversations with many other lenders who are interested to enter into this market.

So we at the institute, we do have huge ambitions for the green mortgage market, as well as the property linked finance market. We think that they address two very different audiences: green mortgages help those people who have an encumbered home (so they already have a mortgage), while PACE can support those homeowners, but it can also support homeowners who have paid off their mortgage or in rental as well. So huge ambitions.

We know that there's obviously, the Heat and Buildings Strategy coming down the line. We have the Spending Review. We have a number of other requirements coming down the line, such as there was a consultation earlier in this year on the role of lenders in supporting home energy efficiency improvements that was launched by the government. So we expect to see some release on whether disclosures and voluntary or mandatory targets will be coming down the line for the amount of financing that lenders must put towards green home improvements. So lots of drivers. And if we can address some of those barriers that Robin mentioned earlier, there's huge opportunities in this space.

Emma Bill:

Thank you, Emma and Robin, for your time today. It's been really great to touch on some of the topics covered in the green finance report. We'll now bring this podcast to a close.